Options Wisdom: Looking Before LEAPing

 |  Includes: BAC, EMC, F, SPY
by: optionMONSTER

By Chris McKhann

As if we need more confusion to the already-perplexing lexicon of the options world, we must also contend with LEAPS. The acronym, which stands for Long Term Equity Anticipation Security, is essentially just a long-winded way of referring to long-term options that are one to two years out.

Not all optionable underlyings have LEAPS, but most of the current ones that do have January 2011 and January 2012 expirations. (Some exchange-traded funds are exceptions.)

Most traders stick to the front-month expiration when they are trading options, as that is where you get the biggest "bang for the buck." Volatility traders often do the same, as volatility "mispricing" tends to be where the volume is.
F Chart

For instance, if we recently looked at the 20-day average volume for the S&P 500 SPDR (NYSEARCA:SPY) and found more than 900,000 contracts average in the February expiration, 300,000 in March, and nothing else above 50,000. In Bank of America (NYSE:BAC), the top name in equity options in one recent session, we saw 176,000 in February and 50,000 in March.

But recent sessions have provided some interesting trades that give an indication of the appeal of LEAPS. On Feb. 17 we saw one trade that sold 5,000 of the EMC Corp. (NYSE:EMC) January 2012 20 calls. A few days earlier another sold 10,000 of the Ford (NYSE:F) January 2012 10 puts. The call selling is likely done against long stock as a covered call position.

Covered calls are the most common options strategy, and naked call selling has unlimited risk potential. So advanced traders will see that the above two positions are virtually identical, as a covered call and short puts have the same risk profile.

Those Ford puts were sold for $2.25. This means that the trader collects $2.25, which was 20 percent of the stock's closing price. The trade is protected down to $7.75, as that is the downside break-even point, the price below which the trade would show a loss at expiration. That is 30 percent below the stock's price.

A 20 percent return--assuming that Ford is above $10 come January 2012--may not sound like much over roughly two years, but most institutional investors would probably jump at that prospect. If shares move higher in the near term, that position will likely be closed out earlier with a better relative return.

Another use of LEAPS is as stock substitutes. Some traders don't like options because of the need for continual rolls to maintain a position. Using LEAPS eliminates such a need.

LEAPS also have relatively low time decay. In-the-money calls tend to have low time premium, even out a year or two. So some traders buy them instead of being long (or short) stocks, as the capital outlay is less.

Disclosure: No positions